chapter 17 tools of monetary policy. copyright © 2007 pearson addison-wesley. all rights reserved....
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Chapter 17
Tools of Monetary Policy
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Tools of Monetary Policy
• Open market operations Affect the quantity of reserves and the monetary base
• Changes in borrowed reserves Affect the monetary base
• Changes in reserve requirements Affect the money multiplier
• Federal funds rate—the interest rate on overnight loans of reserves from one bank to another
Primary indicator of the stance of monetary policy
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Demand in the Market for Reserves
• What happens to the quantity of reserves demanded, holding everything else constant, as the federal funds rate changes?
• Two components: required reserves and excess reserves
Excess reserves are insurance against deposit outflows The cost of holding these is the interest rate that could have
been earned
• As the federal funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded rises
• Downward sloping demand curve
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Supply in the Market for Reserves
• Two components: non-borrowed and borrowed reserves
• Cost of borrowing from the Fed is the discount rate
• Borrowing from the Fed is a substitute for borrowing from other banks
• If iff < id, then banks will not borrow from the Fed and borrowed reserves are zero
• The supply curve will be vertical
• As iff rises above id, banks will borrow more and more at id, and re-lend at iff
• The supply curve is horizontal (perfectly elastic) at id
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Affecting the Federal Funds Rate
• An open market purchase causes the federal funds rate to fall; an open market sale causes the federal funds rate to rise shifting the supply curve
• If the intersection of supply and demand occurs on the vertical section of the supply curve, a change in the discount rate will have no effect on the federal funds rate
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Affecting the Federal Funds Rate (cont’d)
• If the intersection of supply and demand occurs on the horizontal section of the supply curve, a change in the discount rate shifts that portion of the supply curve and the federal funds rate may either rise or fall depending on the change in the discount rate
• When the Fed raises reserve requirement, the federal funds rate rises and when the Fed decreases reserve requirement, the federal funds rate falls shifting the demand curve
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